Forex: How To Scalp Fundamentally

While technical analysis is critical to currency trading - especially for pinpointing entries and exits - it is insufficient on its own for creating a comprehensive trading game plan. Market sentiment in FX is driven primarily by the economic and geopolitical news of the day. The key players in the currency market - Fortune 500 multinationals, the world's central banks, multibillion-dollar hedge funds and the top tier investment banks that service them - do not care if there is a double top in the EUR/JPY on the hourly candles. Instead, they formulate their trades by analyzing the most recent economic news and geopolitical developments, as well as the latest pronouncements from G-7 monetary authorities. Therefore, the proper approach to FX trading can be summarized as follows: trigger fundamentally, enter and exit technically. (You could go directly to our Forex Walkthrough which covers Beginner, Intermediate, and Advanced sections.)

Popular wisdom in the market states that traders who want to trade fundamentally should choose a longer time frame involving daily, or even weekly, charts. Those traders who want to trade more short term (hourly charts, for example) should focus strictly on technical setups. As with so much conventional wisdom in FX, this bit of advice couldn't be more wrong. For the purposes of this article, we define scalping in FX as using short-term time frames (usually hourly charts or smaller) to make trades with targets and stops approximately 20-30 points in length. Not only is it possible to scalp FX fundamentally, but retail traders actually have a significant advantage over larger market players when it comes to executing their trades.

Macroeconomic News Moves the MarketOne of the great aspects of the currency market is that it trades off of macroeconomic news that is transparent, impossible to fabricate and readily available to all market participants at the same time. (To learn more, see our completeForex Walkthrough Economics Section.) The key news that drives the FX market is governmental economic data such as the latest employment statistics, GDP growth rates, trade balance reports, inflation readings and interest rate announcements. These reports are typically released every month and can been previewed on economic calendars.

Not only is the release of this data planned well in advance, but it is also reported instantaneously through a variety of news outlets including Bloomberg, Reuters, Dow Jones and CNBC, making it universally accessible. There's no need for traders to know about a secret contract that Intel (Nasdaq:INTC) may have negotiated, or the super-cool new product that a company like Apple (Nasdaq:AAPL) just prototyped at its labs in Cupertino, California. In FX, headline economic data really does move markets, and currency traders can take advantage of that fact. More importantly, individual traders often have a decided advantage in reacting to the news faster than the larger corporate and hedge fund players.

Retail Traders Can React Quickly As the most liquid financial market in the world, forex trades almost US$2 trillion each day in volume (in April 2004, the Bank for International Settlements (BIS) reported that the forex market traded US$1.9 trillion a day). Most retail brokers will provide liquidity up to $20 million, meaning that they will allow any trader to buy up to $20 million worth of a currency pair at the current ask or to sell the same amount at the present bid. This trade size can accommodate 99% of all retail orders, making it easy for traders to open a position quickly without affecting the market. However, larger players that are looking to place trades worth hundreds of millions or even billions of dollars at a time will move markets. Therefore, by reacting quickly, retail traders in FX have a chance to front-run the big players and benefit from any momentum generated by that order flow. Economic news, whether favorable or unfavorable, can take up to several hours to fully filter through the market as traders adjust to the new information. This type of time frame offers astute retail traders a great opportunity to take advantage of the situation and scalp short-term profits as the pressure from the big players moves prices in the direction of the news.

How the Best Fundamental Scalps Occur If event-driven scalping were as easy as buying good news and selling bad news, every FX trader would be inordinately rich. Of course, success is not that simple. First and foremost, good or bad economic results in and of themselves are usually meaningless to the market. FX markets trade on expectations and perception. Therefore, relative comparisons matter much more than absolute ones. For example, suppose the United States reported quarterly GDP growth of 5%, while the eurozone reported GDP results of only 1.5%. At first glance, it would appear that EUR/USD should decline because the U.S. results clearly show superior growth. However, if the market expected 7% GDP numbers from the U.S. and only 0.5% readings from the eurozone, the exact opposite might occur because eurozone news would have exceeded expectations, while U.S. results would have come up short.

However, playing the expectations game alone is not enough to create profitable trades. This is where technicals become integral to a successful fundamental setup. The best, most profitable fundamental scalps occur under technically extreme conditions. These highest-probability setups are created when a favorable fundamental surprise takes place under technically oversold conditions and vice versa. At that moment, the currency can bounce like a rubber ball off pavement, as every market participant who is short scrambles to cover his or her position. The same dynamic occurs in reverse. If prices are extremely overbought and fundamental news shocks to the downside, most market players will rush for the exits, creating a stampede of sell orders that generates a strong momentum-driven move that can be profitably traded to the downside.

Figure 1

Source: Fxtrek Intellicharts

ExamplesFigure 1 shows an example of an actual fundamental scalp that a trader could have traded in the EUR/USD. On April 6, 2006, the euro was rallying against the U.S. dollar ahead of the monthly meeting of the European Central Bank. Rumors were flying on FX dealing desks that the ECB would surprise the market by raising rates by 25 basis points to 2.75%. The pair had become technically overbought, trading to the upper Bollinger Band® on the hourly charts as traders positioned for the news. When the announcement came that rates would stay the same (at 2.5%), prices receded, forming a red candle on the hourly charts. At the close of that candle, a trader could have gone short at 1.2306 using the swing high of 1.2331 as his or her stop and targeting the lower Bollinger Band® value of 1.2250 as his or her profit. (To learn more, see The Basics Of Bollinger Bands® and Using Bollinger Band® "Bands" To Gauge Trends.)

Notice that the trader in this situation would be using technicals for his or her entries, stops and exits, while using the fundamental data to trigger the trade, reasoning that disappointment from the ECB announcement would cause a retrace in the pair. Later on in the morning, ultra-dovish commentary by ECB chief Jean Paul Trichet helped push the pair much lower - the currency trader would have come out of the trade with a profit of 50 points in less than an hour. (For more insight, read Get To Know The Major Central Banks.)

Figure 2

Source: Fxtrek Intellicharts

Figure 2 shows a good example of why both technical and fundamental considerations are critical to successful event-driven scalping. On April 12, 2006, unemployment figures from the U.K. seriously disappointed forex traders, showing an increase of 12,500, rather than the market projections of an increase of 6,500. (For further reading, see Surveying The Employment Report.)

GBP/USD prices had been rising steadily for days as the pair climbed over the important 1.7500 level. Prices were clearly overbought, with the pair trading near the upper Bollinger Band®. A trader might have reasonably expected the news to trigger a sell-off, as the market would have to reassess its optimistic view of the U.K. economy. However, if the trader jumped the gun and shorted the market right away instead of waiting for some technical confirmation of price weakness, he or she would have gotten into some trouble. Why? Because instead of trading lower, the pair burst higher as pound longs tried hard to ignore the negative news and made one last effort to rally prices. As a result, the trader who jumped the gun would've been stopped out, losing 30 points only to watch in dismay as, two hours later, the price action finally exhausted itself and the fundamental facts began to weigh on the market. Therefore, triggering fundamentally but entering without a sound technical signal can hurt the forex trader.

Conclusion Trading FX is a multifaceted affair that requires both fundamental knowledge and technical expertise. Not only is scalping on economic news possible, it can be highly lucrative - as long as the trader pays attention to technicals as well as fundamentals. Like all worthwhile ventures in life, scalping fundamentally is not easy to achieve. It takes time and practice to learn this methodology, but those who are able to master this approach can enjoy long-term success in the currency market. For further reading, take a look at our Forex Walkthrough.